Why I’d buy this hidden gem ahead of this FTSE 100 8% yielder

The share price of British Gas owner Centrica (LSE: CNA) has been in decline for five years. It’s fallen from over 400p to a current level of under 150p. There have been dividend cuts along the way, taking the payout down from 17p in 2013 to 12p for the past three years. However, despite the reduced dividend, the shares have fallen so far that the running yield at the current price is a massive 8%.

Stumbling giant

In its annual results in February, the FTSE 100 giant posted a 25% decline in adjusted earnings per share (EPS) to 12.6p, only just covering…

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The share price of British Gas owner Centrica (LSE: CNA) has been in decline for five years. It’s fallen from over 400p to a current level of under 150p. There have been dividend cuts along the way, taking the payout down from 17p in 2013 to 12p for the past three years. However, despite the reduced dividend, the shares have fallen so far that the running yield at the current price is a massive 8%.

Stumbling giant

In its annual results in February, the FTSE 100 giant posted a 25% decline in adjusted earnings per share (EPS) to 12.6p, only just covering the 12p dividend. Normally, a super-high yield and poor dividend cover would indicate a likely future payout cut, but my Foolish colleague Roland Head argued that Centrica could be an exception.

The bull case, which rests on management meeting its targets for cost savings and limiting capital investment, is certainly worth considering. However, the business continues to lose customers in a competitive environment and I see significant downside risk. Management’s targets appear ambitious to me, particularly with the government’s proposed cap on standard variable tariffs. As such, I don’t see a great margin of safety in the company’s price-to-earnings (P/E) ratio of 11.7.

Furthermore, on the dividend front, the consensus forecast of City analysts has moved to a cut (11.8p), but I find myself in agreement with those at the bearish end of the spectrum. For example, Morgan Stanley models an 8p payout, but also adds, “it could well be lower than this.”

Utilities are supposed to provide investors with steady returns at relatively low risk. Centrica has delivered anything but this over the years and the future looks no more promising to me. However, while I rate this stumbling FTSE 100 giant a ‘sell’, there’s a hidden gem in the utilities sector — a ‘blue-chip small-cap’, I’d call it — that I’d happily buy.

For the six months to 31 March, it posted an 8.7% increase in EPS on 4.3% higher revenue, and the board lifted the interim dividend by 5%. Management described profits as being, “at a level commensurate with a sustainable rate of return typical for a regulated utility and at a quantum needed to maintain our continued investment in infrastructure.”

The company, which is 62% owned by The States of Jersey (the government of the British Crown dependency), has long operated in a stable political environment and has balanced the needs of its stakeholders. This includes steady returns for equity investors, who have seen an average total return of 9.3% a year over the last 10 years, compared with 6.1% for the FTSE 100 and 0.9% for Centrica.

The shares are trading 1p higher at 475p on the back of today’s results. With trailing 12-month EPS of 36.6p, the P/E is a reasonable 13, while a well-covered 14.5p dividend gives a running yield of 3.1%. I see no reason why the company can’t go on delivering consistent returns for its shareholders long into the future.

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G A Chester has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.